Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Tongling Jingda Special Magnet Wire Co., Ltd. (SHSE:600577) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Tongling Jingda Special Magnet Wire's Net Debt?

As you can see below, at the end of June 2024, Tongling Jingda Special Magnet Wire had CN¥4.39b of debt, up from CN¥3.61b a year ago. Click the image for more detail. However, it does have CN¥1.50b in cash offsetting this, leading to net debt of about CN¥2.90b.

A Look At Tongling Jingda Special Magnet Wire's Liabilities

We can see from the most recent balance sheet that Tongling Jingda Special Magnet Wire had liabilities of CN¥5.94b falling due within a year, and liabilities of CN¥934.6m due beyond that. On the other hand, it had cash of CN¥1.50b and CN¥5.83b worth of receivables due within a year. So it actually has CN¥454.6m more liquid assets than total liabilities.

This short term liquidity is a sign that Tongling Jingda Special Magnet Wire could probably pay off its debt with ease, as its balance sheet is far from stretched.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Tongling Jingda Special Magnet Wire's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 6.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way Tongling Jingda Special Magnet Wire could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Tongling Jingda Special Magnet Wire's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Tongling Jingda Special Magnet Wire actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Tongling Jingda Special Magnet Wire's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that it has an adequate capacity to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Tongling Jingda Special Magnet Wire's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Tongling Jingda Special Magnet Wire is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.